I don’t understand the discount factors on the value of a caplet / floorlet, on p 162 of the secret sauce… It says (for a 2-year cap): Step 1: Calculate the expiration value of the 2-year caplet at each node at the end of year 2 using the formula: expiration value of caplet = max[0, (1-yr. rate - cap rate) * notional principal] / (1 + 1-yr. rate) Step 2: Bring the terminal caplet value from step 1 back to today. […] What I don’t understand: The value calculated is the value at the end of year 2. Why do we discount using (1 + 1-yr. rate). Does it mean that the value is paid 1 year after, i.e. at the end of year 3? Is that it? Could you confirm?
You discount it twice because you discount from year two to year one and then from year one to zero - similar to what you do in FCFF, FCFE, and residual income questions as well.
mhannebert you are correct